Rules for Bank Capital Still Broken After Four Years

May 7 (Bloomberg) -- It has been four years since the
global financial crisis first struck, and the system that helped
cause the deepest economic slump since the 1930s is still
broken.

Sure, laws have been passed and financial rules tweaked;
the U.S., for instance, in 2010 approved the wide-ranging Dodd-Frank law. But a critical component of a stronger financial
system -- an internationally coordinated increase in bank
capital -- is missing.

U.K. and European Union finance ministers fell out over
this last week. And it’s already clear that the new capital-adequacy rules, when finally in place, will be too weak.

International regulators are debating how to implement the
accords, known as Basel III (after the Swiss city where
agreements on how banks should be funded are often negotiated).
The previous system, Basel II, totally failed. It required too
little capital and let banks invest in some risky securities,
including sovereign debt, as though they were risk-free. This
helped bring on the financial meltdown. Sadly, the new rules on
capital are only a small improvement -- and that’s assuming they
aren’t further watered down in the implementation.

Wafer-Thin Capital

Bank capital is of paramount importance because it is
capable of absorbing losses. If a well-capitalized bank gets
into trouble, its shareholders suffer, but depositors, the
taxpayers who insure their deposits and the rest of the
financial system are protected. Wafer-thin capital -- in other
words, huge leverage -- was the main reason the crash propagated
as it did.

The new accord proposes that banks maintain equity capital
of 4.5 percent of risk-adjusted assets, plus a 2.5 percent added
buffer. Equity of 7 percent is an improvement over Basel II, but
still far less than needed. Even under the new regime, some
supposedly risk-free assets would require little or no capital
backing, so equity as a proportion of total assets would be
lower. Basel III sets a floor of just 3 percent for equity as a
proportion of total assets. A much higher figure -- as high as
20 percent of assets -- is called for.

When figures like that are mentioned, bankers recoil in
horror, and governments fall for it every time. If banks had to
set so much capital aside, they say, they wouldn’t be able to
lend as much -- and governments surely want them to lend?

This is a fallacy, as finance scholars keep explaining. (If
you want clarity on this point, read this paper by Stanford’s
Anat Admati.) Capital isn’t “set aside.” It’s a source of bank
funding, not a use of bank funding. Telling banks to raise more
equity does not limit their capacity to lend.

It does reduce returns to bank shareholders. But if banks
are safer -- and making them safer is the whole point -- the
return on their equity should be lower. And some of the return
enjoyed by banks’ owners reflects the implicit subsidy that
taxpayers hand over to banks deemed “too big to fail.” By making
banks safer, extra capital reduces the value of this subsidy,
and hurts banks’ profits. Again, that’s a good thing.

Because Basel III is too weak and on track to fail,
international regulators should ideally start over, but that
isn’t going to happen. The crucial thing now is for national
regulators to see Basel’s requirements as a minimum (which,
technically, they are) and go much further unilaterally. The
U.K., among other things, wants to keep the power to apply
stricter standards than Basel III (as interpreted by the EU)
would require. Unpopular as this may be in Europe, the U.K. is
right to insist.

Banks Push Back

Banks everywhere will push back against the idea that Basel
III is just a start. If the U.S. sets much tougher capital rules
than other countries, its banks will complain that they have
been put at a competitive disadvantage and will demand a level
playing field.

In a way, they’ll be right. A level playing field would be
good. But if international coordination produces a bank-capital
regime that continues to subsidize banking and is far too weak -
- and that’s how things are shaping up -- the choice for
national regulators is clear. They can have safe banks that
operate at some competitive disadvantage or unsafe banks that
compete on level terms. Reflect for one moment on the costs of
the recession, and the choice is easy.

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